Growth of Australia's major trading partners (MTPs) was around its long-run average
in 2014. The US economy continued to strengthen, growing above its trend pace
over the second half of 2014. In China, economic growth eased a little but
was still very close to the authorities' target for 2014. Growth of investment
and industrial production in China – which contribute significantly to
the demand for commodities, including iron ore – have moderated over
the past year or so, partly because of weak conditions in the residential property
market. In Japan, economic activity has been weaker than expected since the
increase in the consumption tax in April last year, but growth looks to have
resumed in the December quarter. In the rest of east Asia, the pace of growth
slowed a little over 2014. Economic activity in the euro area remains subdued.

Australia's MTP growth is expected to continue at around its pace of recent years
in 2015 as a number of effects offset each other. Growth in China is expected
to be a little lower in 2015, while growth in the US economy is expected to
pick up further. The significant fall in oil prices, which has largely reflected
an increase in global production, represents a sizeable positive supply shock
for the global economy and is expected to provide a stimulus to growth for
Australia's MTPs. The fall in oil prices is also putting downward pressure
on global prices of goods and services. Other commodity prices have also declined
in the past three months, though by much less than oil prices. This includes
iron ore and, to a lesser extent, base metals prices. Prices of Australia's
liquefied natural gas (LNG) exports are generally linked to the price of oil
and are expected to fall in the period ahead. The Australian terms of trade
are expected to be lower as a result of these price developments, notwithstanding
the benefit from the lower price of oil, of which Australia is a net importer.

Central bank actions were the main focus of financial markets over the past few months.
The European Central Bank announced its intention
to ease monetary policy further to prevent inflation from remaining below target
for a prolonged period, by increasing both the size and scope of its asset
purchase program to include government bonds. Several other central banks have
eased policy and financial markets have pushed back their expectations for
policy tightening by the Federal Reserve and other central banks. As a result
of these actions, and some concerns about global growth and the risk of declining
inflation, sovereign bond yields in the major markets have fallen significantly,
particularly at longer maturities, although the size of the decline in yields
is difficult to explain.

The increasingly divergent paths of monetary policy among the major advanced economies
have led to some sizeable movements in exchange rates. Most notably, the Swiss
franc has appreciated by around 15 per cent against the euro since the Swiss
National Bank abandoned its exchange rate ceiling against the euro at an unscheduled
meeting in January. While the US dollar has depreciated against the Swiss franc,
it has appreciated further against most other currencies, notably the euro,
and is around 10 per cent higher on a trade-weighted basis than it was in mid
2014. Nevertheless, in real terms the US trade-weighted exchange rate remains
below its long-term average.

Australian financial conditions remain very accommodative. Lending rates on the outstanding
stock of housing and business loans have continued to edge lower, and yields
on Australian government bonds have fallen considerably. The Australian dollar
has depreciated by around 9 per cent against the US dollar since the previous
Statement. On a trade-weighted basis it has depreciated by 7 per cent
over the same period, and is currently 5 per cent below its early 2014 levels,
although commodity prices have fallen by considerably more since then.

Available data since the previous Statement suggest that the domestic economy continued to grow at a
below-trend pace over the second half of 2014. Resource exports and dwelling
investment have grown strongly. Consumption growth remains a bit below average.
Growth of private non-mining business investment and public demand remain subdued,
while mining investment has fallen further.

Export volumes continued to grow strongly over the second half of 2014, driven by
resource exports. Australian production of coal and iron ore is expected to
remain at high levels, despite the large fall in prices over the past year.
The production capacity for LNG is expected to rise over 2015. Service exports,
including education and tourism, have increased a little over the past two
years or so and are expected to rise further in response to the exchange rate
depreciation.

Mining investment continued to decline as some current projects reached completion
and very few new projects were commenced. This is expected to continue for
some time. Non-mining business investment has been subdued over recent years
and the recent data suggest that it will remain so into the first part of 2015.

Activity and prices in the housing market continue to be supported by the very low
level of interest rates and strong population growth. Dwelling investment has
grown strongly since mid 2013 and a range of indicators point to further growth
in the near term. Housing price inflation has eased from the very rapid rates
seen in late 2013, although it remains relatively high, particularly in Sydney
and Melbourne. Growth of owner-occupier housing credit has remained at around
6 per cent, but investor credit continues to grow at a noticeably faster rate.

Household consumption growth has picked up since early 2013, but is still below average.
Consumption is being supported by very low interest rates, rising wealth, the
decision by households to reduce their saving ratio gradually and, more recently,
the decline in petrol prices. These factors have been offset to an extent by
weak growth in labour income, reflecting subdued conditions in the labour market.
Consumption growth is still expected to be a little faster than income growth,
which implies a further gradual decline in the household saving ratio.

Although the most recent data on the labour market have been more positive, including
stronger employment growth, measures of spare capacity have increased over
the past year, consistent with a continuation of below-trend growth in economic
activity. In particular, the unemployment rate increased gradually over 2014,
continuing its trend of the past few years, and the participation rate and
average hours worked remain below their levels of a few years ago. While leading
indicators of labour demand have picked up since late 2013, at this stage they
point to only modest employment growth and a slight rise in the unemployment
rate in the near term. Meanwhile, labour cost pressures remain subdued. Wage
growth remains low and unit labour costs have been little changed for more
than two years.

CPI inflation declined to 1.7 per cent over the year to the December quarter, partly
reflecting the direct effect of the large fall in oil prices and the repeal
of the carbon price. The various measures of underlying inflation declined
in year-ended terms to around 2¼ per cent. Prices of tradable items
(excluding volatile items and tobacco) were little changed in the December
quarter and over the year, following a period of some years in which they had
been in decline. The pass-through of the depreciation of the Australian dollar
is expected to place upward pressure on the prices of tradable items for some
time, but liaison reports suggest that retailers are currently finding it difficult
to pass on the costs of higher import prices because of the highly competitive
retail environment. Non-tradables inflation (excluding utility prices) was
unchanged in the December quarter and continues to reflect the offsetting effects
of weak domestic cost and margin pressures, and ongoing strength in the growth
of new dwelling costs.

GDP growth is forecast to remain a bit below trend over the course of this year,
before picking up to an above-trend pace in the latter part of the forecast
period as consumption growth improves, non-mining business investment lifts
and LNG exports increase. While the key forces shaping the outlook are much
as they were at the time of the November Statement, the forecast for GDP growth has been revised a little lower
in the near term. Notwithstanding the recent falls in oil prices, new information
suggests that consumption growth and non-mining business investment are likely
to pick up later than previously had been expected, and that LNG production
is likely to ramp up a bit more gradually than earlier expected. Lower export
prices are expected to dampen the growth of incomes and activity. In time,
however, the recent further depreciation of the exchange rate and lower interest
rates are expected to provide support to demand. As a result, GDP growth is
expected to be above trend in the latter part of the forecast period.

The slightly weaker outlook for GDP growth in the near term implies that the unemployment
rate is likely to rise a bit further and peak a bit later than earlier expected,
before declining as growth picks up to an above-trend pace. The outlook for
consumer price inflation has been revised lower since the previous Statement, reflecting the effects of the fall in oil prices and the
weaker outlook for labour and product markets. These have more than offset
the upward pressure on prices anticipated to result from the further exchange
rate depreciation. Headline inflation is expected to remain low for a time,
before picking up a bit to be consistent with the inflation target at the end
of the forecast period. Underlying inflation is expected to remain well contained
and consistent with the target throughout the forecast period.

Overall, the risks to the global economic outlook appear to be broadly balanced.
Weakness in the Chinese property market is an ongoing source of uncertainty
for the growth in China's demand, including for some of Australia's
key commodities. Chinese authorities have taken measures to support residential
construction activity but, to date, housing market conditions remain subdued.
Economic conditions in the United States could strengthen by more than forecast
in response to still very stimulatory monetary policy and the decline in oil
prices. More generally, the extent of the stimulus to global economic activity
from the decline in oil prices is a source of uncertainty.

Moreover, the outlook for commodity prices is a key source of uncertainty for both
the global and the domestic economies. The outlook for prices will depend on
a number of factors, including the responsiveness of future supply to the decline
in commodity prices seen to date. The outlook for the exchange rate is also
an important consideration for the forecasts for the domestic economy. Most
estimates suggest that the Australian dollar remains above its fundamental
value, given the substantial decline in commodity prices over the past year.
Increasingly divergent monetary policies in the major economies are likely
to continue to have an important bearing on exchange rate developments.

There is considerable uncertainty about the combined effect of the fall in oil prices
and the depreciation of the exchange rate on domestic economic activity and
inflation. Lower oil prices will provide support to household demand and benefit
businesses (outside the oil and gas sectors). The lower exchange rate will
help to switch demand to domestic sources of production as it pushes up import
prices and improves the competitiveness of firms in the traded sector. The
magnitude and timing of these effects are, as always, uncertain. The same is
true of the extent to which the exchange rate depreciation passes through to
consumer prices; this could be slower or faster than historical relationships
suggest.

The timing and extent of the expected decline in mining investment and the anticipated
recovery in non-mining activity remain key uncertainties for the domestic outlook.
While this transition has been unfolding for some time, assisted by the very
low level of interest rates, there is a risk that the recent run of moderate
growth in household consumption could persist. However, the potential for ongoing
strength in housing price inflation across the country could be associated
with stronger-than-expected growth in consumption. Given the large increases
in housing prices in some regions and ongoing strength in lending to investors
in housing assets, housing market developments will need to be watched carefully.
The Bank is working with other regulators to assess and contain economic risks
that may arise from the housing market.

The timing and speed of the anticipated recovery in non-mining business investment
remains uncertain. While the recent data suggest that the anticipated pick-up
will occur later than had earlier been expected, the fundamental factors supporting
investment remain in place, including very low interest rates, strong population
growth and a period of weak investment over the past few years. If the appetite
for businesses to take on risk improves, the eventual pick-up in non-mining
business investment could be stronger than currently forecast.

Prior to the February Board meeting, the cash rate had been at the same level since
August 2013. Interest rates faced by households and firms had declined a little
over this period. Very low interest rates have contributed to a pick-up in
the growth of non-mining activity. The recent large fall in oil prices, if
sustained, will also help to bolster domestic demand. However, over recent
months there have been fewer indications of a near-term strengthening in growth
than previous forecasts would have implied. Hence, growth overall is now forecast
to remain at a below-trend pace somewhat longer than had earlier been expected.
Accordingly, the economy is expected to be operating with a degree of spare
capacity for some time yet, and domestic cost pressures are likely to remain
subdued and inflation well contained. In addition, while the exchange rate
has depreciated, it remains above most estimates of its fundamental value,
particularly given the significant falls in key commodity prices, and so is
providing less assistance in delivering balanced growth in the economy than
it could.

Given this assessment, and informed by a set of forecasts based on an unchanged cash
rate, the Board judged at its February meeting that a further 25 basis point
reduction in the cash rate was appropriate. This decision is expected to provide
some additional support to demand, thus fostering sustainable growth and inflation
outcomes consistent with the inflation target.